The Corp. Of The Problem

Revisionist Theory...The recent revisions to the original 1Q GDP report a few weeks back deserve
mention. If for nothing more than to reinforce the point that we're a long
way from being able to characterize the current economic recovery as self sustaining.
The headline number was only revised down to 5.6% from 5.8%, but as is usual,
it's the messages that lurk in the shadows of the revision that are most important.
Cutting right to the chase, in our minds, the most important component revisions
to the 1Q GDP number can be found in final sales and inventories. In prior
discussions, we have pointed out that the current year over year rate of change
in final sales rests at a four decade low. Originally reported as a 2.6% gain
in 1Q, the revision now shows a 2.0% increase. Completely coincidental was
the fact that "final sales to domestic purchasers" was revised from
3.7% to 3.0%. It's not the end of the world, but certainly highlights one of
two interrelated points that frame the character and texture of the current
economy.

Final sales to domestic purchasers rests at a revised year over year rate
of change low only seen during the final two quarters of 1991 (the jobless
recovery), and then not since 1961. As you know, it is strength in final sales
that will ultimately light the way to this recovery being something more than
largely inventory driven. The reason we take a peek at sales to domestic purchasers
is that it is possibly a more clear gauge of the health of the US economy specifically
from the standpoint of broad based domestic-only consumption, as opposed to
the aggregate final sales measure itself. It just so happens that the 1Q revision
reveals downwardly revised segment growth rates in consumer, business fixed
investment and government spending. Likewise, all major sub-components of these
sectors experienced downside revision. Lastly, the Fed's own favorite little
marker of final sales, real private final sales, was revised to 0.6% from 1.1%.
Theoretically, real private final sales strips out the influence of government
spending and inventories. Bottom line on all of this? Final sales, the next
significant link beyond the inventory rebuild in an academically classic economic
recovery, remains tepid at best by historical standards.

The second highlight in the revised 1Q GDP report was indeed inventories.
In this case the upward revision to the positive impact of inventories on calculated
GDP is a downward revision to inventory de-stocking. Instead of American companies
burning through ($36.2) billion in inventory as originally surmised, they only
used up ($25.7) billion in net inventories. Very quickly, a quarter over quarter
decline in inventory reduction is additive to GDP. (Don't you just love those
double negatives?) Bottom line? As opposed to accounting for an absolute 3.1
of the original 5.8% 1Q GDP number, the reduction in inventory de-stocking
on the revision means that inventory activity alone accounted for 3.6 of the
5.6% new and improved GDP calculation. Plain and simple, without inventories,
economic growth in 1Q was a heck of a lot closer to a 2% kind of affair than
not.

It's a bit interesting in that given a current year over year growth rate
in final sales similar to what was seen in 1991, that inventory reduction experience
has been so much more dramatic an exercise this cycle. Maybe not so surprising
in that the late 1990's was characterized by incredible capital spending and
a resulting escalation in physical capacity. Relative to nominal GDP as a whole,
the dollar amount of inventory reduction at its bottom this cycle was twice
as much as what was experienced during the early 1990's recession nadir. The
following chart is a look at the absolute inventory activity of each period:

The current revisions to 1Q GDP simply reinforce the message that inventories
were the driving force behind the most current 1Q spurt of academic economic
activity. At least for now. A bit disconcerting in that this type of academic
lift to the GDP calculation is ultimately temporary and demands consumer, business
and government follow through if it is to be nurtured ahead.

The Corp. Of The Problem...As you know, in addition to inventories
supporting the academic rise in GDP, the consumer has been lauded for refusing
to even temporarily jump off the consumption bandwagon during the so-called
recession. Relative to historical precedent, consumers basically missed the
fact that there has been a recession. Corporations, on the other hand, were
fully informed and acted accordingly. As we look ahead, many of the tailwinds
that at least psychologically supported household consumption during the fourth
quarter of last year and first quarter of this year are dying down. The initial
rush of tax rebates and refunds are now yesterday's news. Current refi activity
is well south of record experience seen during the last six to nine months.
The influence of 0% auto financing is largely gone, but being cushioned a bit
by continued rebates of various form. And energy prices seen primarily in retail
form at the gas pump are well up from 52 week lows. The majority of what have
been very short term transitory or cyclical stimulants to consumption are behind
us. Lastly, auto sales and the monthly variability in the price of gasoline
have partially distorted the reporting of retail sales. Stripping out these
two swing factors over the last eight months reveals a touch more sanguine
view of aggregate retail sales than not:

There simply isn't a whole heck of a lot of weakness for the consumer to recover
from, as seen in the above chart. This suggests to us that incremental growth
in consumer spending from here will be linked directly to labor market conditions.
And in the wonderful economic food chain of life, labor conditions will be
driven by corporate profitability. Simple enough?

Simultaneous with the temporary stimulants to consumption dissipating, the
labor markets continue to weaken at the margin. Last month we spent the bulk
of the discussion addressing why we believed labor was in for further deterioration
ahead. We simply did not have to wait long for validation of the thought process.

During the past month the unemployment rate has risen to a new high for this
cycle. It has actually been seven and one half years since the official unemployment
number in this country has kissed 6%. We have been living in a low unemployment
rate world for such a long time that 6% now seems like one heavy number. The
fact is that just prior to the rather painful recessionary period of the early
1980's, this is the number near where the unemployment rate bottomed before
almost doubling into the recession itself. Early peaks, drops, and then subsequent
reacceleration upward in the unemployment rate is actually the rule as opposed
to the exception of recessions past. Although these movements often appear
as blips on the screen, the so far current experience is typically similar
to what has come before:

Given the current day to day anecdotes regarding the labor market in the aggregate,
we have not yet seen the top in official unemployment for this cycle. It lies
ahead.

Lastly, directly reflective of the current uncertainty at the corporate level
regarding business conditions ahead is continuing jobless claims experience.
As you know, we continue to see attention grabbing headline layoff announcements.
But the anomaly of this cycle for now is continuing claims. Never in any recession
of the last 30 years have continuing jobless claims peaked, dropped temporarily
and then resumed their ascent to new highs. The pictures tell the story:

As you can see, during the recessions of the mid-1970's and twin recessions
of the early 1980's, continuing claims made clean peaks and subsequent near
vertical drops as recoveries took hold.

It was in the early 1990's that continuing claims remained stubbornly high
in a period that came to be characterized as one of jobless recovery;

Although the early 1990's economic recovery began as one where the labor market
remained weak for a good 18 months following the academic conclusion to the
actual recession, the Fed at the time was just warming up in terms of getting
ready to take short term interest rates into a kamikaze spiral to help the
beleaguered banking system reliquify during the period. Interest rate actions
that not only eventually helped kick start job growth once again, but also
supplied a much broader liquidity stimulant to the financial markets as the
1990's bull market in equities was getting ready to lift off.

In our current circumstances, the Fed has already completed at least the bulk
of its death defying interest rate plunge. Far surpassing the depths of what
was seen in the early 1990's. Although we are still relatively early in the
economic recovery game for now, continuing unemployment claims are acting much
differently than anything seen in the past. This is where we find ourselves
at the moment:

A sharp drop in continuing claims from here might suggest that the economy
is about to accelerate independent of the short term influence of the inventory
cycle. A move in claims to even higher highs might imply that the now consensus
dismissed possibility of a double-dip recession may in fact turn into some
type of quasi-reality. For now, the characterization of jobless prosperity
heard far and wide in the early 1990's seems to fit the best with current experience
to this point. Yes, the economy is recovering, but for the consumer, this reacceleration
in continued claims is a new experience for a post recessionary environment.
In our minds, the bottom line ahead for consumers rests with corporate profitability.
The incredibly simplistic transmission mechanism is as follows. Corporate earnings
increase, labor conditions improve, consumer incomes rise and consumer spending
increases.

As you know, reported corporate earnings in 2002 already have one built in
perceptual boost driven by lessened goodwill charges via accounting standards
mandate. The influence on cash flow of the accounting change for goodwill is
zero. Corporate cash flows in 2002 will receive a bit of a jump start from
recent tax legislation that accelerates current depreciation allowances, academically
lowering corporate cash tax liabilities. And lastly, cost containment measures
at the corporate level have been and continue to be significant for this cycle.
But a longer term recovery in corporate earnings is not going to be built on
the back of cost cutting and tax changes. The drop in nominal corporate earnings
during the recent so-called recession has been one of the worst experiences
of the last half century. Without significant healing on the part of corporate
earnings, sustainable employment growth is not in the cards near term. Without
employment growth, from where will consumer income growth originate?The stock
market? Another housing refi cycle? Or none of the above?

She Digs Her Heels In The Stallion's Flank Again...For now, the Fed
is caught in a bit of a box regarding monetary policy, the need to resuscitate
the corporate economy, and macro global capital flows. The confluence of these
factors ultimately being crucial to the outcome of the current domestic economic
chess match. Although many a corporation in the US has been increasingly denied
access to the commercial paper markets, especially in terms of excessive issuance,
as this period of financial reconciliation advances, a good portion of the
cost of capital in corporate America is still quite beholden to the short end
of the yield curve vis-à-vis the generosity of the interest rate swap
market.

When an example such as a GE can cut back on low cost short term commercial
paper placement, issue higher yielding longer term fixed debt as a substitute,
and claim that their cost of capital remains unchanged, the importance of the
interest rate swap market to the corporate community (and corporate CFO's in
particular) is highlighted in flashing red neon. To make a long story short,
corporations have not needed to issue actual commercial paper to be beneficiaries
of commercial paper like rates (cost of debt), they simply need to call up
their favorite derivatives desk and enter into an interest rate swap agreement.
Hence, a good chunk of corporate debt these days is quite levered to the short
end of the yield curve. Certainly this miracle of modern finance has not been
lost on the Fed in terms of FOMC interest rate decision making.

Having said this, we suggest watching changes in money supply over time as
a gauge of partial Fed accommodation actions outside of the interest rate mechanism.
A perfect indicator? No, largely because credit (money) can easily be created
outside of the in good part Fed influenced banking system. It just so happens
that about $100 billion in new M3 has arrived on the scene over the last four
weeks. Enough to catch our attention. Important in our minds in that we are
firm believers in at least a partial linkage between money acceleration, activity
in the financial markets, and the economy. In the following chart, we look
at the monthly changes in broad money (M3 plus commercial paper) and the NASDAQ.
Although it is certainly far from a perfect correlation, directional changes
in broad money tend to lead subsequent directional change in an equity index
such as the NASDAQ by about a month or so.

As is certainly no secret, the modus operandi of the Fed influencing money
supply growth over the past half decade or so in response to potentially significant
shorter term financial market and/or economic disruptions is now virtually
an expectation. But the monkey wrench that has been thrown into the equation
of the moment is global capital flows, as measured by the votes of currency
traders far and wide - the value of the dollar relative to foreign currency
alternatives. As we mentioned in a discussion very early in 2002, one of our
main concerns for the year ahead was the continuation of global capital pouring
into dollar denominated financial and real assets. Change at the margin has
indeed come to foreign purchases of dollar denominated assets this year. Relative
to prior periods, the rate of change in foreign based accumulation is slowing.
Foreign investment in US assets has been one of a number of crucial cornerstones
to continued global attractiveness of dollar denominated investments. A key
link in the virtuous circle. The current value of the dollar is an implicit
vote by the foreign community that rate of return in dollar denominated assets
may be less than what is currently available in non-dollar denominated investments.
Whether the absolute reality is true or not, it's the perception that counts
short term.

This brings up the question of whether the Fed will now need to use the money
supply to attempt to combat problems on yet another front - the battle lines
of global capital movement. Although this is very short term in nature, the
following chart reveals that temporary peaks in the dollar this year through
the first quarter have been coincidental with peaks in M3 change.

Once again, money supply has accelerated upward substantially in the past
month with an as of yet lack of corresponding move up in the dollar. Or the
financial markets. Is the box within which the Fed finds itself constricting?
Is the simultaneous need to reinvigorate corporate earnings growth (and hoped
for employment and consumer income growth), maintain domestic financial market
stability, and keep the dollar relatively stable or orderly in price action
too much for the diminished financial ammunition box of the Fed?

Never in recent US economic experience has the Fed begun to raise rates prior
to the domestic unemployment rate peaking. Never in recent experience has the
Fed begun to raise rates prior to corporate capacity utilization bottoming
and having turned up measurably in each cycle. Trying to juggle the current
domestic economic recovery along with the dollar and the financial markets
just may mean that the "nevers" of yesterday are about to be tested.

Shadow Boxing The Apocalypse?...To suggest that the historical price
of gold has been driven at least in good part by emotion over the past thirty
years is probably an inexcusable understatement. In trying to continually look
for differences in the here and the now financial and economic environment
relative to what history provides in the way of guideposts and markers, the
price action of gold is a current anomaly. As you can see in the following
chart, subsequent to every recession of the past 30 years, the price of the
bullion has fallen. In some cases fallen for years afterward. No mystery given
that falling inflation has been a hallmark of post recessionary periods.

If the current recession is over, why is gold acting differently relative
to historical precedent? Of course the answers to that question are more than
numerous. If indeed we are just living through a short term trading oriented
and influenced price spike anomaly, history would suggest that the price of
gold will fall as the economy recovers. If, however, gold continues to move
higher, the price action may be suggestive of the fact that other financial
and/or economic systemic factors are different today as opposed to the experience
of prior recessionary precedent. Gold is fast approaching an important longer
term technical downtrend top line begun during the late 1980's. A breakout
above that downtrend line will certainly attract the attention of just about
every technician on the planet (who has not already been attracted by the recent
shine of the metal). But, if gold continues to move higher within the context
of an economy that continues to muddle through in positive territory, the much
larger message may be that macro economic and financial system reconciliation
for this cycle is far from fully played out.

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